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Beat the Market the Harvard Endowment Way

By    |   Monday, 22 September 2008 08:37 AM

Individual investors spend most of their time and effort looking for the next big winner in the stock market.

Institutional investors, such as pension fund managers, take a different approach. They tend to devote the majority of their decision-making process to asset allocation instead.

A huge winner in the asset allocation sweepstakes has been Harvard's endowment fund, the Harvard Management Company. Its current manager is Jane Mendillo, who previously ran the $7 billion Wellesley College endowment fund.

At Wellesley, she earned 13.5 percent during her five-year tenure, beating the market each year.

A lot of the fund's recent fame, of course, belongs to its recent former manager, Mohamed El-Erian, CEO of bond fund Pimco.

Asset classes is an interesting and useful tool, strategically speaking. An allocation is merely how much of stocks, bonds, and cash you hold at any given time. Foreign stocks, foreign bonds, real estate, and commodities are additional investment options available to institutions like Harvard which control hundreds of millions of dollars of investable assets.

Academic studies have shown that the asset allocation of a portfolio accounts for the difference between mediocrity and success in institutional performance. It is not the selection of individual stocks or bonds driving their individual performance. It is actually the amount invested in each broad asset category that makes the difference in the long-term.

In his recent book "When Markets Collide: Investment Strategies for the Age of Global Economic Change," El-Erian highlighted the importance of asset allocation.

In one of his most surprising conclusions, El-Erian recommended holding only 15 percent of your investment portfolio in U.S. stocks. A traditional model, in comparison, allocates at least 40 percent and up to 60 percent to U.S. stocks.

This advice stands in stark contrast to the wisdom of most financial planners, many of whom even today consider a 10 percent weighting in foreign stocks as a ceiling for risk.

Harvard University has the largest endowment fund among American colleges. While there, El-Erian managed $38 billion for the fund, which has a long history of beating the market.

In the 12-month period ending June 30, for instance, The Wall Street Journal reported that Harvard realized gains of about 8 percent. This came at a time when the market declined by 15 percent.

The broad asset allocation decisions made by Harvard Management Company have been reported as:

  • U.S. stocks: 12 percent

  • Foreign developed market stocks: 12 percent

  • Emerging market stocks: 10 percent

  • U.S. bonds: 13 percent

  • Foreign bonds: 3 percent

  • Real estate: 9 percent

  • Commodities: 17 percent

  • Private equity: 11 percent

  • Hedge funds: 18 percent

  • Cash: negative 5 percent (indicating the level of borrowing required to duplicate this portfolio)

    Individual investors can duplicate the Harvard endowment portfolio using exchange-traded funds (ETFs):

    Vanguard Total Stock Market ETF (VTI) captures the performance of the overall U.S. stock market. Vanguard is best known for pioneering low-cost mutual funds, and their ETFs continue this tradition. VTI has an annual expense ratio of only 0.04 percent. Recent price: 58.54.

    iShares MSCI EAFE Index (EFA) yielded 5 percent at a recent price of 55.21. The MSCI Europe, Asia, and Far East Index covers 21 foreign stock markets in developed countries, allowing investors to place a diversified bet on the global economy.

    iShares MSCI Emerging Markets (EEM) offers access to emerging market stocks. These markets, which include Brazil and Russia, offer the greatest potential returns and the greatest risk to investors. The dividend yield of 2.7 percent at the recent price of 31.55 provides some comfort to investors in this volatile ETF.

    Vanguard Total Bond Market ETF (BND) is a low-cost investment in intermediate-term bonds. BND has an expense ratio of only 0.11 percent and pays a 4.63 percent yield at the recent price of 76.76.

    SPDR Lehman International Treasury Bond (BWX) ETF buys and holds government securities issued by foreign countries. BWX pays a monthly dividend, and has returned almost 3 percent to investors since it began trading in October 2007. It was recently trading at 51.40.

    iShares Cohen & Steers Realty Majors (ICF) has returned a total of 15.48 percent over the past five years, the best in its category. The ETF yielded 4.43 percent at a recent price of 73.82.

    Elements S&P CTI ETN (LSC) tracks the S&P Commodity Trends Indicator Total Return Index. The index consists of 16 highly liquid commodity futures diversified among six sectors. The recent price of this newly introduced ETF was 8.71.

    PowerShares International Listed Private Equity (PFP) offers investors exposure to worldwide private-equity companies, which trade at an average P/E ratio of 8. Private equity companies take stakes in companies which aren’t listed on stock exchanges. PFP traded at 15.62 recently.

    KEYnotes First Trust Enh 130/30 LgCp ETN (JFT) was recently trading at 34.85. This ETF mirrors the First Trust Enhanced 130/30 Large Cap index. It is designed to offer 130 percent long and 30 percent short exposure to large-capitalization U.S. stocks. The long/short leveraged portfolio is a popular strategy among hedge fund managers

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    Individual investors spend most of their time and effort looking for the next big winner in the stock market. Institutional investors, such as pension fund managers, take a different approach. They tend to devote the majority of their decision-making process to asset...
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